Your ability to stay subjective and use the CFA curriculum will distinguish you as an analyst and asset manager
As the S&P 500 climbs to record highs almost on a daily basis, companies are starting to release their earnings for the second quarter. If earnings estimates are correct, the second quarter will mark the fifth consecutive quarter of year-over-year earnings declines.
That trend in earnings weakness hasn’t happened since the third quarter of 2009. As a result of the record high index and weaker earnings, valuations are set to climb even higher. The S&P 500 is already trading for 24.9 times trailing earnings of the companies in the index, 17% higher than its multiple this time last year.
This post isn’t really about earnings and the stock market though but about how you as an analyst need to be able to step back from the chorus of the market and manage your client’s money subjectively.
But Forward Earnings Aren’t So Bad
Against the dizzying heights we see in trailing P/E valuations, I hear more analysts and TV pundits talk about forward earnings to rationalize how the stock market isn’t too expensive. The 12-month forward P/E is a more reasonable 16.6 for the S&P 500, just 16% above its ten-year average of 14.3 times expected earnings.
Joachim Klement, CFA makes a very good point about the Forward P/E in a recent post on Enterprising Investor, the CFA Institute’s practical analysis blog. Klement compared the returns on the lowest P/E stocks against the highest P/E stocks across four international indexes. He ran the test first using trailing P/E multiples and then for Forward P/E multiples.
The result pointed to the perennial over-optimism of analysts and forward expectations. For the S&P 500, the cheapest group of stocks on a trailing P/E basis typically outperformed the most expensive stocks by 1.2% on a rolling basis. Using Forward P/E multiples though, the ‘cheapest’ stocks actually underperformed the more expensive set by one percent.
Relying on Forward P/E multiples as a measure of value just doesn’t work. Klement points out data that shows analyst expectations are, on average, 10% higher than actual realized earnings.
The issue isn’t just about being wary of forward estimates or investor sentiment in your job as an analyst but being generally critical on what you see in the market. I’m not saying the seven-year bull market is setting up for an imminent collapse but no bull runs forever. It’s usually as stocks get pricey and valuations get stretched that we see excuses for why ‘this time is different’ and some reasoning that supports valuations that are much higher than the historical averages.
Warren Buffett called out a warning earlier this year in his shareholder address, which we shared on the Finquiz blog. The Oracle of Omaha warned about the rising promotion of ‘adjusted’ earnings rather than reported numbers according to generally accepted accounting principles (GAAP).
Companies have always adjusted their earnings for one-time and extraordinary numbers and often have tried to soothe investors by pointing out other temporary factors but it seems recently the practice has gone much farther.
For example, dollar strength has weighed on earnings at U.S. corporations for more than a year. Over the last few quarters, I’ve noticed companies putting much more emphasis on their ‘currency-neutral’ earnings. Sometimes it’s difficult to even find their reported numbers with the currency effect.
None of these warnings on the use of forward multiples or adjusted earnings are new. It is all highlighted many times in the CFA curriculum, most clearly in the section on Accounting Shenanigans and Warning Signs.
What will distinguish your career as an asset manager and an analyst is your ability to stay subjective against everything you hear in the market. As everyone else starts marching to the same drumbeat, your ability to step back and use the material you learned from the CFA curriculum will help you spot opportunities both on the long- and the short-side of the trade.
‘til next time, happy studyin’
Joseph Hogue, CFA